Paulson Engineers U.S. Takeover of Fannie, Freddie (Update4)

By Rebecca Christie and Dawn Kopecki

Sept. 7 (Bloomberg) — The U.S. government seized control of Fannie Mae and Freddie Mac after the biggest surge in mortgage defaults in at least three decades threatened to topple the companies making up almost half the U.S. home-loan market.

“Our economy and our markets will not recover until the bulk of this housing correction is behind us,” Treasury Secretary Henry Paulson, who engineered the takeover along with Federal Housing Finance Agency Director James Lockhart, said in Washington today. “Fannie Mae and Freddie Mac are critical to turning the corner.”

The FHFA will take over Fannie and Freddie under a so- called conservatorship, replacing their chief executives and eliminating their dividends. The Treasury can purchase up to $100 billion of a special class of stock in each company as needed to maintain a positive net worth. It will also provide secured short-term funding to Fannie, Freddie and 12 federal home-loan banks, and purchase mortgage-backed debt in the open market.

The takeovers bring Fannie, formed after the Great Depression and spun off in 1968, and Freddie, created in 1970, back under the government’s fold. It’s the biggest step yet in officials’ efforts to grapple with a yearlong credit crisis that has caused more than $500 billion of losses and writedowns.

Treasury Gets Stock

Under the plan, the Treasury will receive $1 billion of senior preferred stock in coming days, with warrants representing ownership stakes of 79.9 percent of Fannie and Freddie. The government will receive annual interest of 10 percent on its stake.

As a condition for the assistance, Fannie and Freddie eventually will have to reduce their holdings of mortgages and securities backed by home loans.

The portfolios “shall not exceed $850 billion as of Dec. 31, 2009, and shall decline by 10 percent per year until it reaches $250 billion,” the Treasury said. Fannie’s portfolio was $758 billion at the end of July, and Freddie’s was $798 billion.

Officials are aiming “to prevent the mortgage market from falling apart,” said former Federal Reserve Bank of St. Louis President William Poole. The Treasury’s funds “will be flowing in for quite a long time,” Poole, a Bloomberg contributor, said on Bloomberg Radio.

Herbert Allison, 65, former chief executive officer of TIAA-Cref, will take over as Fannie’s new CEO. David Moffett, 56, who was vice chairman of US Bancorp, will head Freddie, Lockhart said. They will work with existing management, he added.

Mudd, Syron Exit

Fannie CEO Daniel Mudd, 50, and Freddie CEO Richard Syron, 64, will serve in a transition period as consultants.

“Americans should be confident that the actions taken today will strengthen our ability to weather the housing correction and are critical to returning the economy to stronger sustained growth,” President George W. Bush said today in a statement released by the White House.

“The actions taken today are temporary,” Bush said. As the administration considers the companies’ future role, “it is critical that they not pose similar risks to our economy and to our financial system again.”

While common stockholders of Fannie and Freddie won’t be eliminated under the conservatorships, they will be last in line for any claims, Paulson said. Preferred shareholders will be second in absorbing losses, he said.

`Restoration Plans’

Banks and insurance companies have typically purchased the two companies’ preferred shares. The Federal Reserve and three other bank regulators said that they will work to “develop capital restoration plans” with the “limited number” of smaller institutions that hold Fannie and Freddie stock as a significant portion of their capital.

By ensuring that Fannie and Freddie maintain positive net worth, the Treasury will provide “additional security” to the owners of Fannie and Freddie bonds and “additional confidence” for the holders of their mortgage-backed securities, it said. The Treasury noted that Fannie and Freddie securities are held by central banks and “investors around the world.”

Lockhart added that interest and principal payments will continue to be made on the companies’ subordinated debt.

The government is taking an increasing role in financial markets, after the Fed six months ago provided $29 billion of financing to prevent Bear Stearns & Cos.’s collapse. Chairman Ben S. Bernanke praised today’s action in a statement.

`Inherent Conflict’

The plan doesn’t answer all of investors’ questions about the companies’ long-term prospects. It also doesn’t address the question of whether the companies will be nationalized, privatized, or kept as government-sponsored enterprises that are shareholder owned. Paulson said that “only Congress” can tackle the “inherent conflict” of serving shareholders and a public mission.

“Keeping them alive is the wrong approach,” said Peter Wallison, a fellow at the American Enterprise Institute in Washington and a former Treasury general counsel. “They need to be sustained, they’re essential to financing housing right now. But it doesn’t mean that they have to be maintained as GSEs.”

Wallison added that if Fannie and Freddie return to profitability, “then what the shareholders have is worth something.”

Lobbying Ban

Congress has long avoided making major changes to the two companies, which have had extensive lobbying operations. Lockhart said today that those operations will cease.

“All political activities — including all lobbying — will be halted immediately,” Lockhart said. “We will review the charitable activity.”

Democratic presidential nominee Barack Obama said today that “some” intervention was necessary to prevent a “larger and deeper crisis,” while adding that the ultimate resolution of the firms’ status will need to be addressed.

Free-marked advocates such as former Fed Chairman Alan Greenspan and Richmond Fed President Jeffrey Lacker have called for the two companies to be split up and sold off.

“Debt holders still face uncertainty, especially regarding what happens in 2010 and what is the business plan going forward,” said Eric Johnson, president of Carmel, Indiana-based 40/86 Advisors Inc., which manages $25 billion in fixed-income assets.

$5 Billion Purchase

Starting with a $5 billion purchase this month, the Treasury will buy new mortgage-backed securities from the two companies, in an effort “to broaden access to mortgage funding for current and prospective homeowners,” according to the Treasury.

The Treasury will hire independent asset managers to purchase and run the portfolio of mortgage-backed securities it will buy. “There is no reason to expect taxpayer losses from this program, and it could produce gains,” the department said.

For Bill Gross, manager of the world’s biggest bond fund at Newport Beach, California-based Pacific Investment Management Co., today’s announcement was good news.

“We own lots of mortgage-backed bonds, and I would expect on Monday and in the ensuing weeks for them to do very well,” Gross said in a Bloomberg Radio interview. “So yes, I’m smiling at the moment.”

Inflated Capital

Paulson’s decision, taken after consulting with Bernanke, followed a review that found Washington-based Fannie and McLean, Virginia-based Freddie used accounting methods that inflated their capital, according to people with knowledge of the decision.

Paulson, 62, hired Morgan Stanley a month ago to probe the companies’ finances. The investment bank concluded that the accounting, while legal, enabled Freddie, and to a lesser extent Fannie, to overstate the value of their reserves, according to the people who declined to be identified because the findings were confidential.

Robert Scully, an adviser to Morgan Stanley CEO and Chairman John Mack, and Ruth Porat, head of global financial institutions, led a 39-person team at the investment bank that explored a range of alternatives for Fannie and Freddie.

Morgan Stanley, officials and regulators determined it was too risky for the companies to try to raise money themselves, because of the losses on many private capital injections in the past year, two people involved in the discussions said. They also deemed a Treasury capital infusion without a government takeover as too risky for taxpayers, the people said.

No End Date

The FHFA will aim to “preserve and conserve” the companies’ assets and property and put them “in a sound and solvent condition,” according to a fact sheet distributed by the Treasury. There is “no exact time frame” for when the conservatorship will end, the statement said.

Fannie and Freddie own or guarantee almost half of the $12 trillion in U.S. home loans and the government had been leaning on the companies to help pull the economy out of the housing crisis.

Concern over the companies’ capital pushed their borrowing costs to record levels over U.S. Treasuries, sent their common and preferred stocks tumbling and boosted mortgage rates. Fannie is down about 66 percent in New York Stock Exchange trading since the end of June. Freddie has fallen about 69 percent.

Paulson briefed Republican presidential candidate John McCain, Obama, and the Democratic and Republican leaders of the House and Senate. Senate Banking Committee Chairman Christopher Dodd and House Financial Services Committee Chairman Barney Frank and their Republican minority counterparts were also informed.

Congressional Reaction

“Paulson has threaded the needle just right by taking necessary action to stabilize U.S. financial markets while minimizing the liability for taxpayers,” Democratic Senator Charles Schumer of New York, who heads the congressional Joint Economic Committee, said in a statement. “This plan will be met with broad acceptance in Congress because it doesn’t prejudge the ultimate fate of Fannie Mae and Freddie Mac.”

Other congressional statements indicated hearings are likely as soon as this week.

Fannie was created by the government in 1938 as part of President Franklin D. Roosevelt‘s New Deal. Freddie was chartered in 1970 to compete with Fannie.

As losses on the mortgages grew late last year, the companies recorded $14.9 billion in combined net losses, eating into their capital. Fannie raised $14.4 billion since November and Freddie sold $6 billion of preferred securities. Plans for a $5.5 billion sale were delayed as the company’s fortunes sank.

Required By Regulator

Fannie had $47 billion of capital as of June 30, according to company filings. The company is required by its regulator to hold $37.5 billion. Freddie’s capital stood at $37.1 billion, compared with a requirement of $34.5 billion, filings show.

Fannie’s market capitalization is now $7.6 billion, down from $38.9 billion at the end of last year. Freddie‘s has fallen to $3.3 billion, from $22 billion over the same period.

Bernanke participated in the meetings because the central bank was given a consultative role in overseeing Fannie’s and Freddie’s capital under legislation approved in July.

The FHFA was scheduled to release its assessment of the companies’ capital levels as early as last week as part of a quarterly appraisal of their finances.

To contact the reporter on this story: Rebecca Christie in Washington at Rchristie4@bloomberg.net; Dawn Kopecki in Washington at dkopecki@bloomberg.net

Last Updated: September 7, 2008 17:23 EDT

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